External costs

Definition of External costs

  • An external cost occurs when producing or consuming a good or service imposes a cost upon a third party.
  • If there are external costs in consuming a good (negative externalities), the social cost will be greater than the private cost.
  • The existence of external costs can lead to market failure. This is because the free market generally ignores the existence of external costs.

Example of External Cost

pollution-smog

Driving a car imposes a private cost on the driver (cost of petrol, tax and buying car). However, driving a car creates costs to other people in society. These can include:

  • Greater congestion and slower journey times for other drivers.
  • Cause of death for pedestrians, cyclists and other road users.
  • Pollution, health related problems.
  • Noise pollution.

Example of Production External Cost

  • Producing electricity from burning coal leads to air pollution and acid rain.
  • Producing chemicals can cause pollution to air and water.

Diagram showing effect of external cost (production)

negative-externality-id

This diagram shows how the existence of external costs will cause the social marginal cost to be greater than the private marginal cost. Therefore, in a free market, there will be overconsumption of the good (Q1). Social efficiency will occur at Q2 where SMC = SMB

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